Currency risk and ETFs, trackers, and other funds

One area where investors and even experts get themselves into a muddle is currency risk – specifically when it comes to the currency that a fund is priced or denominated in.

Currency risk itself is pretty straightforward, and familiar to anyone who has ever been on holiday or who owns a property abroad.

Let’s say you’re a British resident who’s headed to the U.S. for a vacation in three months. You decide to take some dollars with you, and you opt to convert a whopping £1,000 into dollars because you’ve heard that you’ll need to tip big to avoid a lynching.

You’re also very old-fashioned, so you want to get this sorted out three months in advance. Ignoring transaction costs1:

At a rate of £1:$1.60, your £1,000 buys you $1,600 dollars

Let’s suppose that before your holiday, the pound strengthens so that £1 now buys $2. But you’ve already changed your money, at the old rubbish rate!

At the new rate of £1:$2, your $1,600 is now worth (1,600/2) = £800

Ouch!

It could have gone the other way. Currency risk has upside as much as downside.

Currency risk and the underlying assets

Converting holiday money is straightforward – and exactly the same thing happens when you make overseas investments.

Let’s say that rather than going on holiday, you do what I’d do – being a tightwad – and put £1,000 into a tracker fund that follows the US market instead.

All the stocks in the tracker fund are based in the US, listed on the US markets, and priced in dollars as you’d expect. Your US tracker fund is therefore buying a bunch of US dollar denominated assets.

Three months later, the exchange rate is £1:$2. If the US stock market has not changed over the period, you’d log on to your broker and see:

Your investment is now worth $1,600/2 = £800

Of course it’s more likely the market would also have moved over three months, as well as the exchange rate. If the US market had gone up 10%, your investment would be worth £880. If it had fallen 10%, you’d be looking at a princely £720.

In fact, it’s usually stock market moves not currency moves that will dominate your returns. (Also, currency changes usually – though not always – happen more slowly than in my example, which I just dialed to ‘high’ to make my point.)

Fund denominations don’t matter

Safari, so-goody, as Christopher Biggins used to say in a kid’s TV program that has me showing my age.

Where people get confused is when they buy a fund that is denominated in a currency other than that of the underlying investment.

A typical example would be a UK-traded ETF that tracks the Japanese market, but is denominated (/priced) in euros.

The mistake people make is they think they are exposed to multiple currency risks – in this case the euro as well as the Japanese yen.

This is wrong – you are only exposed to the underlying asset’s currency.

Lots of people make this slip. For example, Morningstar has an article up as I write that states:

…unless, of course, you really know what you’re doing when it comes to forex and, for example, you want to take a bet that emerging market currencies will appreciate against the euro, that the euro will appreciate against sterling, and that these events will converge in time for when you choose to sell your shares.

The implication of this quote is that a UK investor who buys an emerging market fund that’s denominated in euros faces a double-whammy of two currency risks – the pound versus the euro, as well as versus the emerging market currencies.

That’s incorrect. As a UK investor you’re only exposed to emerging market currency risk in buying the euro-denominated fund. The exchange rate between the pound and the euro is irrelevant!

Currency risk: The science bit

I’ll show why it’s the underlying asset currency that matters in two different ways.

First I’ll use a bit of algebra, and then we’ll go through a real-life example.

Algebra first.

Let’s say you are a UK investor who has rather oddly decided to buy a euro-denominated ETF that holds only UK shares.3

The Euro-priced ETF holds UK-listed assets – BP, Tesco, Lloyds, and so on – that are denominated in sterling.

(1) The quoted price of the ETF in euros:

= Value of UK holdings * (pound/euro exchange rate)

Now let’s say you log into your UK fund platform to find out what your ETF investment is worth today in pounds – your native currency.

Clearly its £ value is equal to the value of the ETF in euros, adjusted for the euro/pound exchange rate.

(2) In other words, the value of the ETF in £:

= Price of ETF in euros * (Euro/pound exchange rate)

Now we can substitute (1) into equation (2) to give us the value in pounds as:

In other words, as a UK investor who is investing pounds, this fund of UK assets is worth its value in pounds, regardless of whether it’s priced / denominated in euros, yen, or Malaysian ringgits.

What about if you were a UK investor buying a euro-priced ETF that invested in the Japanese stock market?

Here the underlying assets are Japanese, so the exchange rate that matters for a UK investor is the pound/yen exchange rate.

To see this, we can modify my equation above to take the value of the ETF in pounds to be:

= Value of Japanese holdings * (Pound/euro rate) * (Euro/Yen rate)

= Value of Japanese holdings * (Pound/Yen rate)

Again, the pricing currency (here it’s euros) is irrelevant and vanishes from the equation. The euro introduces no extra currency risk.

Note: Some funds hold a lot of cash, which may introduce an additional currency risk. If for example you own a European-based investment trust that invests in Japanese equities but that holds 10% of its assets as cash in euros, then as a UK investor you do face currency risk on those euros, as well as on the much larger exposure to the Japanese yen. Cash held by ETFs and trackers is usual trivial, however, and can be disregarded.

Currency risk in the real-world

Let’s really drive the point home with a real-world worked example.

Imagine the Japanese tracking ETF mentioned above comes in two denominations – the original euro-denominated ETF that we looked at above, and another one denominated in pounds sterling.

As a UK investor, you’d be naturally drawn to the ETF denominated in pounds. But in theory it makes no difference which one you buy5.

On 4 January 2013 you decide to cash out. Over that time the Japanese stock market rose to 10,688 – a gain of 27.4%.

So your investment in local yen terms is:

= 119,500 yen plus the 27.4% gain

= 152,243 yen

We now have to convert back into pounds. Turning again to Google Finance, I see that on 4 January 2013:

£1 buys 141.6 yen

So your investment is worth in pounds:

= 152,243 / 141.6

= £1,075

Notice that although the local market went up 27.4%, you ‘ve only gained 7.5% in pounds. That’s because the pound strengthened against the yen, which meant your yen bought fewer pounds when converted back into sterling. This is true currency risk in action.

Hopefully that was pretty easy to follow. Butwhat if you’d bought the euro-denominated ETF?

Trickier to work out, as we need to know a couple more exchange rates.

On 6 January 2012:

One pound bought 1.21 euros

One euro bought 98.6 yen

So – deep breath! – you again invest £1,000:

£1,000 = 1,210 euros

1,210 euros = 119,472 yen

As we saw, the Japanese market rose 27.4% over the year.

This time your investment in local terms:

= 119,472 yen plus a 27.4% gain

= 152,208 yen

Checking on Google Finance, I see on 4 January 2013:

One pound bought 1.23 euros

One euro bought 115.2 yen

So converting back:

152,208 yen = 1,321 euros

1,321 euros = £1,075

Magic! Again you have ended up with £1,075, despite the fact you invested via a euro-denominated ETF.

The exchange rate changes between the pound and the euro have disappeared from the equations. It is the exchange rate between your currency and the currency of the investment – in this case the yen – that matters, and determines your currency risk.

Why this happens: Related currency pairs are perfectly inter-connected, which is what enables the denominating currency to ‘disappear’ above. If this wasn’t the case, then you could profit when currency exchange rates got out of kilter. For example, you could might be able to convert pounds into yen, and then convert those yen into euros, and then convert those euros back into your original currency, pounds, for a profit. You can’t do this because the currency markets are extremely liquid, deep, and efficient, and any miniscule opportunities like this are immediately arbitraged away.

Currency risks and rewards

Don’t be surprised if you see people saying something different to the above. They’re wrong and I’m right, as the worked example I plodded through above proves, even if you weren’t convinced by my elegant algebra.

Check the figures with Google Finance if you don’t believe me! And see this similar example that uses the Thai baht.

The takeaway should be clear:

Currency risk is determined by the local currency of your foreign asset.

Even if you buy a vehicle that is priced in your own currency, such as a UK investor buying a UK-listed ETF that’s denominated in pounds, if the fund invests in overseas stocks then you’re exposed to the currency risk of the underlying assets.

Despite the scary name, currency risk isn’t necessarily a bad thing, as you can win as well as lose. Also, it’s another kind of diversification and so can reduce risk.

You don’t want to completely ignore your home currency. If you’re going to be a UK pensioner, it would be madness to have all your assets in Japan. One day you’ll need to spend pounds in the shops and you don’t want to be completely at the mercy of the prevailing pound/yen exchange rate when you retire.

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The costs of exchanging money at airport booths and so on are massive in the real world, and you should explore all the different ways to pay abroad – but that’s another article. [↩]

One small caveat is there may be money changing charges made by the fund or charged by your broker when converting from one currency to another racked up along the way. But that is a separate issue. [↩]

As throughout this article I’m ignoring small currency related transaction costs that are a different issue [↩]

I am going to ignore small rounding errors throughout for clarity. [↩]

Hah, anyone that makes that mistake should be limited to only buying Vanguard Lifestrategy funds. Do they not understand what equities are? (Equal slices of a company.)

It’s probably worth saying that while people typically don’t bother hedging currency risk in equities for the reason that that’s not the major source of volatility, they _do_ tend to take out currency effects for bonds if they hold them. This _does_ make sense as the currency fluctuations would tend to dominate and the purpose of bonds is to provide stability.

Occasionally, not hedging currency can reduce volatility: I dipped my toe into Japan a year or so ago as I believed Abenomics would work. Here it all depended on the currency falling, so if things didn’t work and the markets didn’t respond I imagined I’d gain from the relative strength of the yen!

I don’t understand the lingo. For example, from Mish’s blog: “I see little value anywhere except gold, cash, and Yen-hedged equities.” Does that last phrase mean Japanese equities with the currency risk reduced by hedging into USD?

I’m taking it that currency hedging can be done cheaply and safely with a suitable ETF. Are such ETFs eligible for ISAs?

You are relying on (a/b)/(c/b) usually equating to (a/c). This is true, /unless/ b is zero (or infinity). Fortunately this is unlikely, except perhaps if one of the currencies involved is from the Weimar Republic or Zimbabwe (and even then may just be very small or exceptionally large).

That sentence should say ‘almost perfectly’. The inter-connectedness can break down for short periods of time, usually during a crisis when everyone is (metaphorically) fleeing for the hills including the currency arbitrageurs who ensure that the inter-connectedness exists, so there is a small element of extra risk but probably not enough for the average person to worry about.

@dearieme — It means that from the perspective of a US investor who has US dollars, your currency exposure would aim to be reduced or eliminated, so you would only be exposed to the returns from the Japanese market (minus the usual costs and fees of course). Hedging is not cost-less — it will usually drag on returns, and in an opaque fashion, depending on how the hedging is achieved.

If you bought that dollar-hedged ETF, then as a UK investor you’d face currency risk with the dollar (I’m presuming — I haven’t read up on the exact details). As a UK investor, if you wanted to reduce or eliminate currency risk when investing in Japan you’d want a sterling-hedged product

Going long the Japanese market with currency hedging has been a particularly popular trade for US hedge funds because part of the reason that Japanese equities have rallied is specifically because the Yen has fallen. So to get the full benefit of the gain, they looked for hedged exposure (the smart/lucky ones before the Yen fell…) It’s not always so neat like this — and it can reverse, too, which would then see their hedge cost them in relative terms, if the Yen reversed substantially. There are various feedback loops with currencies and their domestic markets (because imports/exports become cheaper/more expensive for one thing, as well as for fund flows) which makes it all a bit of a guessing game. And if the average investor does badly picking stocks, well successfully predicting currencies makes stock picking look like Tic-Tac-Toe!

But as Greg says the good news is long-term investors who invest widely and globally in equities probably shouldn’t bother with hedging, and instead prefer to get the diversification benefits of exposure to multiple currencies. Generally equity returns will dominate your results from shares, not currency changes (and where they don’t the currency move was likely unpredictable anyway, except with 20-20 goggles on). The Mishes of the world who only see value in cash, gold, and one market in the world are clearly short-term tactical traders so fair enough if he wants hedged exposure, but that’s not the game most of us are playing.

Bonds are different both because the returns are lower (so they can’t overwhelm currency risk), because they’re not infinite duration like equities, and also because the feedback loops you see with equities pretty much don’t exist because with fixed income the income stream and eventual return of capital are fixed, unlike with equities where, say, Toyota can benefit from a lower Yen which may make up for the value of your Yen holdings falling. (On an aggregate level there may be some tweaks — e.g. A Government may effectively issue more debt to foreign investors in response to currency changes etc — but that’s an even more convoluted matter, and well beyond my skill set!)

I recall research from (I think) the London Business School producing some evidence a few years ago that hedging fixed interest did improve returns for UK investors, but not with equities. But personally I wouldn’t bother with overseas bonds *unless* it was to get diversification, so for me hedging them would seem counter productive anyway.

In your Japanese ETF example, if it’s denominated in GBP then you’re exposed to currency risk between GBP and JPY. Fine.

But if it’s denominated in EUR you’re exposed to GBP/JPY risk as before. But your broker charges you, say, 1% to convert your GBP to EUR to buy the thing, and then 1% to swap EUR for GBP when you sell. It’s a 1% initial fee and a 1% sale fee, on top of normal dealing charges.

What you could do is hold accounts in EUR, USD, whatever and convert the money yourself (using a cheaper P2P forex company) – but you’ll have trouble finding a broker letting you pay in EUR and it’ll probably charge more anyway. And things like ISAs are restricted to GBP only.

Yep, various fees could be charged at various points depending on the vehicle (even with a unit trust). I mention this in the footnotes — but the article is nearly 2,000 words so I wanted to focus on the big theme. 🙂

You’re still going to have initial currency fees with your multi-currency account but yes, after that it could be cheaper for active traders who churn a lot. (Also cheaper for dividend payers)

Thanks, chaps. I shall soon make a small purchase of equity to rebalance my portfolio (“portfolio”: snort, grunt, chuckle!) so I think, in view of your comments, I might plump for an international Investment Trust. I think I’ll take Independent IT as my base case and compare various others to it.

I am in UK. I have bought into an ETF focusing on US consumer staples. It is listed on the LSE and quoted in dollars. I have just seen that a sister ETF has appeared quoted in GBP. It doesn’t say it’s hedged and the charges are the same. So what does this mean, given that the underlying investment is in US assets trading in the US? Have I lost out somehow?

I’ve been considering currency risk and I’ve decided (for me) it’s not actually a problem in the accumulation stage. I dabble with currency trading (successfully I might add, but it’s only on a small scale) and was considering adjusting asset allocation on the fly as an unleveraged currency play.
It occurred to me that due to what we’re seeing at the moment with QE and how it affects the markets it seems to cancel itself out somewhat, but that any increased volatility caused by exchange rate fluctuations will already be taken advantage of with a globally diversified portfolio through the process of rebalancing.
If I’m already increasing the proportion of bonds as I age, and if I decrease my exposure to overseas equity as well then surely I’ll see mainly benefits from currency risk? A global crash not withstanding of course…
Anyone’s thoughts welcome. Am I mental or have I arrived at the general consensus to currency risk in a roundabout way?

@DW — Yes, speaking very generally, for long-term investors in equities with multi-decade horizons, currency moves are assumed to cancel each other out due to their impacts and consequences, and/or any impact is outweighed by returns from stock market growth.

With fixed income it’s different — currency risk even on a long-term horizon is more of a factor. Of course it could be a good or a bad factor, depending on how things play out. Hence diversification is as ever important if you’re going to buy overseas bonds (or buy hedged products, but that will reduce your return).

For these reasons and others, many portfolios stick to domestic fixed income and only venture abroad with equities.

Good piece on an area that’s not widely covered. So would I be correct in thinking that with a fund purchased in GBP but denominated in Euros where the underlying assets are about 2/3rds USA co’s priced in dollars, then it’s changes in the dollar/GBP exchange rate that would most affect the GBP value of the fund rather than the euro/GBP rate? Also, if the GBP share class of the fund had been purchased instead of the Euro share class, then the fund value stemming from the USA co’s (which is the majority) would be the same as with the Euro share class?

“Imagine the Japanese tracking ETF mentioned above comes in two denominations – the original euro-denominated ETF that we looked at above, and another one denominated in pounds sterling.

As a UK investor, you’d be naturally drawn to the ETF denominated in pounds. But in theory it makes no difference which one you buy.”

So the base currency of such an ETF would be Japanese yen, but it also has a GBP and EUR ticker.

Now the question is, isn’t the bid/ask spread of the market maker higher in the EUR or GBP ticker, than in the Japanese yen ticker?

And who pays the currency exchange cost? Because if the base currency of the ETF is Japanese yen, then if you want to create a GBP and EUR ticker, then you must convert the incoming GBP and EUR money into Japanese yen at some point, and it has a cost.

But then how is it possible that the TER is the same for all the tickers in different currencies? I don’t fully understand this.

Because of there are tickers in different currencies than the base currency, then there is currency exchange cost.

@Bence — I think you’re right that there will be underlying currency exchange costs in the mix, but on big liquid ETFs I think they will be negligible, and possibly offset internally (but I’m speculating). Remember institutions can trade currencies for single digit basis points — very different from us as retail investors. Anyway, if it has an affect and yet quoted TERs are the same then it will show up in tracking difference. I suspect you’re familiar with tracking difference, but there are articles on this site if not (please use search box top right). Another can of worms mind! 🙂

The main point to understand — which is widely misunderstood, even by professionals — is where the currency risk lies. (With the assets, not the fund denomination). Beyond that there will certainly be nuances, but I’d suggest for our purposes it will all come out in the wash of a diversified portfolio.

And what about the premium/discount? If as you’ve written above it doesn’t matter which of these ETFs you buy, the returns would be the same as the underlying assets are in USD, then how come one is quoted as having a premium of 56.25 while the other a discount of 0.36?

@The Rhino — I don’t know the minutia of ETF holdings like some of you guys (and I’m replying on a phone so can’t bare to try to look up) but if you’re saying they’re identical funds only on different venues with different denominating currencies, then yes, the FX charge is an upfront hit, and after that currency risk is the same to a £ investor — that is, exposure to the currencies of the *underlying* holdings. There may also be differences in TER, and I seem to recall there are some fiddly withholding tax issues with US ETFs (try the search tool, top right). Personally I’d always buy an identical UK fund for a simpler life. (Also note can get cheaper FX dealing than 1-1.5% from some brokers).

Update – In this instance, according to YouInvest, no FX charge would be payable as both ETFs are London based. In other words, I think I’m right in saying it makes no difference whether you buy VWRD or VWRL.

Sorry if this sounds a bit dense, just wondering if I could get an opinion..?

I know you cannot time the stock market in terms of buying and selling for prices, but can you time it in regards to exchange rates?

I’ve been buying a SP 500 tracker VUSA which has gained significantly this year due to the GBP drop compared to the USD despite the fact the SP500 has only gained a little. Is it possible to crystallise my gains and cash in these funds and invest in a U.K. orientated fund to try and lock in the gains? Or is it not advised to do this? I’m under the impression the FTSE 100 index is largely international companies so feel converting to these would’t be a massive advantage. Thanks!

@Molar Bear — Hi! 🙂 We can’t give personal advice as to what you should do (re: your comment “is it not advised”).

What I can say is what you’re proposing is just another form of active investing. If you are making that trade because you think it will prove more profitable then staying put then you are saying you believe you know better than the markets the future path of the US dollar versus the pound as well as the future returns of the S&P 500 and the UK market.

Needless to say I am skeptical (but I myself am an active investor, and as far as I am concerned people should do what they think best. But for most people, I think “best” should be passive). That’s not to say your proposed trade won’t work out, perhaps it will. I am saying that from your point of view it will be luck rather than skill. (I’m not being rude, but you’re using phrases like “I am under the impression” etc. The professionals/algorithms you would be betting against in aggregate know where every £ is generated from every country around the world etc. What is your edge over them? Everyone knows the $ is up and the £ is down.)

For what it’s worth, I think currencies are even harder than broad indices which are harder than individual stocks, and most people can’t pick stocks…

A more valid reason to make the switch as a passsive investor is because your asset allocation has become unbalanced and you want to rebalance towards your original allocations.

Hi Investor, sorry for my late reply, I thought I had already. Thank you so much for your reply, much appreciated. You’re absolutely right about not knowing whether the currency and markets will go up and down – despite me thinking that VUSA would have pretty much hit its peak – it’s gone and risen another 4.8% since I posted my question! I have decided to convert most of my holdings of the USA trackers to the Vanguard life strategy 100 fund – essentially I will be rebalancing this way and diversifying a lot more too! Merry Christmas and happy new year!

@The Investor thanks for another superb article. So in short, no it doesn’t matter which currency your ETF is listed in, it’s the assets that are tracked that matter!? I’m paid in USD but also have some income in pounds. I own both VWRD and VWRL is there any advantage right now to say be buying more VWRD now the USD is stronger than say VWRL in Pounds?

@abracadabra — Yep, as the article says it’s the underlying assets that matter for a currency risk perspective. The only real exception to think about is if you’re using your UK broker to buy say a US-listed ETF that pays dividends in dollars. In that instance you’d have an FX charge to buy the foreign ETF and if it paid dividends a charge on those $ payouts being converted back into pounds. (There might also be tax implications).